Can stocks be safer than bonds?

By Felix Salmon
July 5, 2011

y2kurtus leaves an interesting comment, in the context of a world where major sovereign defaults seem increasingly likely:

A topic of great interest the next few weeks will be what is truly the worlds most investable ultra low risk asset. Curently the market says it’s U.S. T-bills and German Euro Bonds.

I’m on the other side of that trade… put my money into ultra-high quality equities which generate meaningful %’s of their earnings in several currencies and whose dividends (untaxable to me in IRA’s) are higher than the 10 year treasury. Like TFF I’m more worried about the dependability of the cashflows than the day to day volitility of the principal.

What y2kurtus is talking about here is stocks like Johnson & Johnson. Its dividend yield is 3.39% — higher than the 10-year Treasury rate of 3.2%. It’s international, and it has very little leverage: total debt to equity is less than 30%.

Such stocks have one clear advantage over any kind of bonds: they’re much less prone to being eaten away by inflation. If you own a company, then you’re selling things which tend to go up in price in line with inflation. And if you own a diversified group of companies, then your inflation risk is much lower than if you own a set of liabilities which are fixed in dollar terms.

And as y2kurtus notes, if the companies are broadly diversified internationally, their stocks should offer decent protection against a plunging currency, too.

On the other hand, when times get tough, companies not only can but should cut their dividends. Just when you need that income most, it’s prone to disappear.

J&J might be paying out 57 cents per quarter right now, but that dividend has been growing at an impressive rate indeed — it was just 5 cents 20 years ago. With hindsight, buying a stock which was going to see its dividend grow by 12% per year compounded would indeed have been a very good idea. (J&J stock was trading at $7.03, adjusted for splits, 20 years ago; it’s $67.30 today.)

But would you have sold the stock by now, if you’d bought back then? One question that y2kurtus leaves open is whether you should sell stocks if and when their dividend yields drop below the 10-year Treasury. JNJ was certainly there — 10 years ago its dividend yield was just 1.4%, when the 10-year Treasury was yielding 5.4%. (And indeed, over the past 10 years, you would have been better off in long-dated Treasuries than in J&J.)

More generally, if J&J’s dividends can go up enormously over time, they can go down enormously over time as well. Companies fail. And on an individual-company basis, there’s no dividend in the world which is remotely as dependable as the coupons on Treasury securities. Even on a diversified basis, dividends are — and should be — cyclical, going up in good times and down in bad times. Which is the exact opposite of what you’d ideally want from an investment. Dividend cashflows have a nasty habit of being “dependable”, in other words, only up until the point at which you actually want to start depending on them.

Remember BP?

BP and Shell between them account for 50% of the dividends paid by UK companies every year. It seems quaint, but there really are a lot of far-from-wealthy people in the UK who live off their dividend income, and those people constitute a surprisingly large part of BP’s shareholder base. If BP suspends its dividend, the only way they can get money from their stock is by selling it.

These small investors didn’t care about volatility of principal at all, so long as they kept on getting their dividends. But the minute that the dividend disappeared, the volatility of the principal became hugely important. And even if you didn’t need to sell your BP shares when it suspended its dividend, any dividend-stock investor would feel a bit of a chump holding onto shares which weren’t paying a dividend at all.

On top of all that, there are good reasons why companies should not declare large dividends, and should spend the money on stock buybacks instead. Why force all your investors to declare dividend income, when buybacks are an elegant way of returning money to the shareholders who want it, while allowing those who don’t to benefit from a smaller float? So long as capital gains taxes are lower than income taxes, a lot of shareholders will be quietly encouraging companies to go the buyback route rather than the dividend route.

So if you’re looking for the worlds most investable ultra low risk asset, I’m not convinced that a portfolio of high-dividend stocks is necessarily the way to go. It just doesn’t make sense to me that an asset which can lose all its cashflows and half its value overnight could ever be considered “ultra low risk”, no matter how sanguine you are about price volatility. And even though you can diversify, that doesn’t tend to work very well during crises.

Still, there is one good thing about holding stocks as part of a low-risk portfolio: you can’t kid yourself that there’s no risk there at all. Debt is treacherous, and hides its risks; with stocks, the risks are out there in the open for all to see. Nothing would be better for reducing the amount of systemic tail risk in the economy than seeing a large number of people coming around to the idea that stocks are safer than bonds. So I applaud y2kurtus for his asset allocation. And maybe, if we see some catastrophic bond defaults, others will follow suit. And we’ll see the kind of painful yet necessary deleveraging which we needed after the financial crisis but failed to get.

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